Friday, June 26, 2009

New Deal 2.0

State and local governments have been forced into draconian budget cuts, firing workers who are among the most reliable in making their mortgage payments–when they have jobs: firemen, policemen, teachers, civil servants.

Yet the Obama administration won’t spend even a small fraction of what it has wasted on the banks to cover state shortfalls. The guarantee of $5.5bn in short term notes for California was deemed to be fiscally irresponsible, yet hundreds of billions have already been allocated to the likes of Citigroup, AIG, and Goldman Sachs, all of whom have already beefed up salaries and bonuses as they emerge from the embrace of the federal government.

Good for the banks, bad for the economy

Banks are also benefiting from lending programs that effectively allow them to borrow at zero and reinvest in Treasuries at around 3%. A bank doesn’t have to do anything to make money. The banks’ return on equity is going to be very good. They are going to be able to restore their finances.

While this is good for banks, is it good for anyone else? The problem is the government’s “free money” program means banks have little or no incentive to do any actual lending. Combined with rising unemployment and the ongoing housing crisis, this means any recovery is likely to be muted, at best, especially given the ongoing weakness in the real estate market.

Giving money to banks does not help fund higher consumer savings and support aggregate demand. The increase in household savings, and subsequent fall in aggregate demand, is what is driving the recession. Thank goodness for unemployment -- that's the only thing driving the Federal deficits needed to fund private savings and stabilize AD, but unfortunately, at a low level. The Obama administration could have taken a "float all boats" approach by cutting payroll tax, and funding private savings that way, but instead chose to enrich bankers and put labor on sale. Banks are pro-cyclical, a strengthening economy will get them to lend, nothing else.

...Except maybe for Federal dictat. Nice post on how the 1970s Community Reinvestment Act, and subsequent legislation and regulatory enforcement, contributed to the housing bubble after all. At the time, I'm sure no one understood how the pieces would come together and create this disaster. Same thing is happening now.

There is all this confusion about banking which I do not understand. I would have thought that this crises would make certain point completely obvious:(1) Banks are pro-cyclical, the amplify what's going on in the broader economy, not drive it(2) The liability side of a bank's balance sheet is no place for market discipline(3) Financial regulation fails(4) Banks should focus on making loans that will be paid back (credit risk)(5) Banks are public-private partnerships(6) The current banking system net destroys value

From this, the core of a new banking structure seems straightforward. The Obama administration does not realize any of 1-6.